On July 3, 2018, the OECD published a discussion draft on the transfer pricing of financial transactions (hereinafter referred to as “discussion draft”).
In general, countries have difficulties reaching agreement on these issues. Therefore, the draft guidance does not reflect the consensus views of the OECD Committee on Fiscal Affairs, but rather the discussion draft identifies the areas of disagreement between countries and solicits stakeholder input on these topics.
The discussion draft is follow-up work from the OECD/G20 base erosion profit shifting (BEPS) plan, more specifically Actions 8-10. The discussion draft offers guidance on how to apply the concepts developed in the new (2017) Chapter 1 of the OECD transfer pricing guidelines, such as the accurate delineation of transactions. It also stresses that the draft is not intended to prevent countries from addressing capital structure and interest deductibility under domestic legislation.
The discussion draft also addresses the economically relevant characteristics that should be considered when analyzing the terms and conditions of financial transactions, including contractual terms, functional analysis, characteristics of financial products/services, economic circumstances and business strategies.
Key general themes arising throughout the discussion draft include:
- The importance of accurate delineation of the actual transaction in advance of considering the pricing;
- A focus on two-sided analyses and consideration of options realistically available; and
- The concept of implicit group support needing to be taken into account in most cases.
The discussion draft also addresses specific transfer pricing issues associated with financial transactions between related parties, such as the treasury function, intra-group loans, cash pooling, hedging, guarantees, and captive insurance. A number of these topics are also addressed in the recently issued Dutch transfer pricing decree of April 22, 2018, no. 2018-6865 (“Dutch TP Decree”). The Dutch TP Decree has replaced the decree of November 14, 2013, no. IFZ 2013/184M, which already included similar guidance regarding financial transactions, such as guarantees, loans and captive insurance. It seems that the Dutch TP Decree may have served as a source of inspiration for some parts of the discussion draft, especially where guarantees and captives are concerned.
A significant portion of the discussion draft introduces the concept and characteristics of the financial arrangements noted above, but in many areas it does not yet provide the detail required to guide taxpayers through to a clear conclusion.
The discussion draft is also seeking stakeholder input when it comes to assessing the arm’s length debt capacity, but does not yet provide much guidance on this topic.
The OECD has invited comments on the discussion draft to be provided by September 7, 2018. In light of the content of the discussion draft, we are expecting commentators to not only seek to address the questions raised, but also encourage the OECD to elaborate on certain topics in order to help them to publish meaningful guidance that genuinely helps taxpayers to navigate some of the challenges in this area.
A non-exhaustive list of other interesting items from the discussion draft has been summarized below.
- If a funder does not perform the decision-making functions to control the risk associated with investing in a financial asset, it should be entitled to no more than a risk-free rate of return.
- Within a group context, the provision of collaterals is not necessarily required, as the lender/parent already has control of and ownership of the assets of the subsidiary, which would make the granting of security less relevant to its risk analysis as a lender.
- Credit ratings are considered “helpful”, whereby some practical limitations (e.g. regarding the use of credit rating tools/software) are identified as well. However, there is no real mention of alternatives in the discussion draft.
- The Comparable Uncontrolled Price (“CUP”) is described, in considerable detail, as a method for determining the arm’s length interest rate using the credit rating of the borrower and taking into account all of the terms and conditions of the loan and comparability factors.
- When considering issues of comparability, the possibility of internal CUPs should not be overlooked. As with external CUPs, it may be necessary to make appropriate adjustments to improve comparability.
- Furthermore, a “Cost of Funds” approach is mentioned, whereby the loan would be priced on the basis of the cost of funds incurred by the lender in raising the funds to lend. To this would be added the expenses of arranging the loan and the relevant costs incurred in servicing the loan, a risk premium to reflect the various economic factors inherent in the proposed loan, plus a profit margin.
- According to the discussion draft, written (“bankability”) opinions/ quotes from independent banks, stating what interest rate the bank would apply were it to make a comparable loan to a company cannot be used to comply with the arm’s length principle, since it is not based on a comparison of actual transactions. Furthermore, it is also important to bear in mind that such letters do not constitute an actual offer to lend. Before proceeding to make a loan, a commercial lender will undertake the relevant due diligence and approval processes that would precede a formal loan offer. Such letters would therefore generally not be regarded as providing evidence of arm’s length terms and conditions. This has been the position of the Dutch tax authorities for many years already.
- A key consideration in analyzing cash pooling arrangements are situations where group members maintain surpluses or borrowing positions which, rather than functioning as part of a short-term liquidity arrangement, become more long-term. It would usually be appropriate to consider whether, on accurate delineation, it would be correct to treat them as something other than a short-term cash pool balance, such as a longer term deposit or a term loan.
- The discussion draft also addresses the remuneration of the cash pool leader. This topic is introduced in a way that the cash pool leader only performs a routine service function and any benefits should thus be distributed to the participants. However, it is also mentioned that, provided the required functional profile is present, the cash pool leader may be entitled to receive all benefits.
- The discussion draft provides three alternatives to approach an allocation of cash pool benefits where required.
- If group members are financially interdependent, the economic risk of a guarantor may not change materially on it giving an explicit guarantee. As in such cases, the guaranteed borrower may not be benefitting beyond the level of credit enhancement attributable to the implicit support of other group members, it can be considered appropriate not to charge a guarantee fee.
- If an explicit guarantee just expands the borrowing capacity of an enterprise, this additional amount may be regarded as equity and the loan considered to be actually given to the guarantor.
The above considerations regarding guarantees broadly reflect what is already included in Section 9 of the Dutch TP Decree.
The final section in the discussion draft, dealing with captive insurance, mentions that a frequent concern when considering the transfer pricing of captive insurance transactions is whether the transaction concerned is genuinely one of insurance, i.e. whether a risk exists and, if so, whether it should be allocated to the captive in light of the facts and circumstances. The discussion draft mentions the following indicators that would typically be expected in an independent insurer:
- there is diversification and pooling of risk in the captive insurer;
- the economic capital position of the group has improved as a result of diversification and there is therefore a real economic impact for the group as a whole (i.e. the captive insurer either: (i) does not only insure group risks but diversifies those group risks by inclusion within its portfolio of a significant proportion of non-group risks, or (ii) it reinsures a significant proportion of the risks it insures outside of the MNE group);
- both the insurer and any reinsurer are regulated entities with broadly similar regulatory regimes and regulators that require evidence of risk transfer and appropriate capital levels;
- the insured risk would otherwise be insurable outside the group;
- the captive has the requisite skills, including investment skills, and experience at its disposal, including employees with senior underwriting expertise;
- the captive has a real possibility of suffering losses.
The above considerations regarding captive insurance broadly reflect what is already included in Section 10 of the Dutch TP Decree. Furthermore, the discussion draft also discusses how to potentially determine the arm’s length prices of captives, including how to deal with group synergies.
The Netherlands can be considered a frontrunner where the transfer pricing of financial transactions is concerned. Already in the 2013 Dutch transfer pricing Decree, specific sections were included on loans, guarantees and captives, which resemble much of the guidance that has now been included on these topics in the discussion draft. In the discussion draft, there is now also an increased focus on the functions performed regarding financial transactions and to whom the benefits of such transactions should be allocated. Furthermore, the pricing of financial transactions is addressed in more detail.
The Dutch guidance has been subject to many discussions between taxpayers and the Dutch tax authorities. Therefore, additional OECD guidance on financial transactions is very welcome and hopefully this discussion draft will, in the end, lead to meaningful OECD guidance that can be used in practice.